Friday, April 26, 2013

Shawn Ritenour critiqued Market Monetarism on the Mises.org blog. I responded to what he sees as our theoretical shortcomings here. He goes on to critique the Market Monetarist view of expectations:

For example, the market monetarists claim that it is expectations about future NGDP that solely determine present investment decisions and hence the direction of the economy. This claim fails to recognize that recessions are not merely the result of decreases in aggregate spending following a boom. They are the result of entrepreneurial error (Hulsmann 1998; Rothbard 2000, pp. 8-9). It is possible, for example, for entrepreneurs to reap profits even in an environment of declining total spending. What matters is not aggregate spending, but the spread between the price of products and the sum of the prices of the factors of production. If the total quantity of all spending in the social economy falls and overall prices fall, firms can still reap profits as long as they identify those projects at which the factors are underpriced relative to the future price of the product they can be used to produce.

Market Monetarist do not claim "that it is expectations about future NGDP that solely determine present investment decisions and hence the direction of the economy. It is rather than we think that expectations about future NGDP are a very important influence on current spending decisions, which determine current NGDP. We believe that both investment and consumption decisions are influenced by expected NGDP, but we don't claim that nothing else influences them.

Most Market Monetarists are skeptical that entrepreneurial errors in investment decisions lead to recession. They rather lead to losses for the particular entrepreneurs that made errors and are usually combined with profits for those entrepreneurs who made correct judgements. For example, an entrepreneur who continued committing resources to maintain the production of CD players loses money while the entrepreneur developing the ipod reaps great profits.

Ritenour argues that it is possible for entrepreneurs to reap profits despite reductions in nominal expenditure. This is true, of course. For example, it is possible for nominal expenditure to fall in aggregate, while nominal expenditure on some particular product rises. However, expectations of reduced nominal expenditure in the future would still result in reduced expenditure now.

Ritenour has in mind a different scenario where firms invest today because they expect that resource prices will fall more than final product prices in the future. In abstract, this is possible. In practice, it would seem a bit difficult unless the shift in money supply or demand were permanent and the adjustment process swift. While a firm spending now on relatively high priced capital goods would take a nominal loss after a general deflation of prices in the future, replacement costs of the capital goods and the real value of profits in terms of consumer goods would be the same. However, if the deflation is temporary, wouldn't the replacement costs be the same and the real profits permanently decreased? Further, a firm using debt to finance investment in the face of an expected deflation of prices and wages is asking to have net worth stripped away by creditors, one way or another.

This sort of reasoning suggests that expectations of recession and deflation bring the recession and deflation right away. If it is permanent, it causes whatever damage it will cause, and recovery, including real investment, can then begin in the context of lower prices and lower wages. If the deflation is temporary, then expectations of the deflation move it to the present as before, though expectations of recovery and a return of the price level to its previous value will also shift recovery nearer to the present.

Ritenour accuses Market Monetarists of inconsistency:

Additionally, the form of expectations assumed is the source of a particular inconsistency in the market monetarist literature. This inconsistency, in turn, is also related to their failure to understand recessions as the result of a cluster of entrepreneurial error. Market monetarists assume that markets are efficient and forward looking. At the same time recessions are due to decreases in expected NGDP. If markets are efficient while forward looking, how can there be a cluster of entrepreneurial error? It seems that if market participants make efficient adjustments while looking forward, there should not be widespread mistakes made by entrepreneurs. If so, how can there be recession? Perhaps the response might be, as Christensen (2011, p. 5) implies, that although people have expectations that are indeed rational, they are not perfect. Even so, if market participants properly forecast that the Fed would not or could not continue to increase NGDP through 2008, why should there be a recession? If their forecast was correct, they should have acted accordingly and markets would clear, and at the very least there would not have been widespread persistent unemployment.

Market Monetarists, like most economists, don't accept Rothbard's assertion that recessions are about a "cluster of entrepreneurial errors." In my view, in a world of creative destruction, entrepreneurial error is rife. Contemplation of the rate business failure and the number of workers that are laid off even when real output and employment are both growing strongly suggest that the market system is quite able to somehow manage massive entrepreneurial error, but also substantial variation in error without there being a recession.

How is that possible? Here is one possibility. In the context of growing aggregate spending on output, business failure results in lower supply, higher prices, and higher nominal and real profits. This attracts more entry, allowing employment and production to recover, while reducing prices and profits return to their initial levels. While real business cycles due to variation in entrepreneurial error would seem possible, it appears that the corrective process works quite well.

Market Monetarists believe that in fact expected expenditure on output influences current expenditure on output. We also argue that a monetary regime that commits to return expenditure on output to a stable growth path as soon as possible will create expectations that will result in smaller decreases (or increases) of current spending on output relative to the target growth path than a regime where there is no such commitment. Further, given any such deviation, the return to the target growth path will be more prompt. A commitment to return nominal GDP to a target growth path will tend to keep spending on output on the target growth path.

Market Monetarists also believe that if prices and wages all adjusted more or less in proportion to the change in spending on output, real output and employment would not be much impacted by the change in spending on output. However, Market Monetarists believe that in fact prices and wages are very sticky with respect to shifts in spending on output, not only in their levels but in their growth trajectories.

Market Monetarists don't have any unusual explanation for sticky prices and wages. Unlike new classical economists and apparently some Austrians, we are willing to accept the evidence we see rather than insist on theoretical arguments that markets must always clear. My view is that the problem is one of coordination. If there were a single firm making price and wage offers, it could more easily adjust to shifts in spending on output. In the real world, the appropriate price and wage for each firm to set depends on what all the other firms will do.

I also recognize that this is true of spending on output. How much it is appropriate (or possible) for any one firm or household to spend depends on how much other households and firms are currently spending. But that doesn't mean that expectations of future spending don't directly impact spending now. The Market Monetarist view isn't that a commitment to keep nominal GDP on a target path is sufficient to keep nominal GDP on that path, it is just that it will do better than a monetary regime that makes no such commitment.

Of course, it is easy to find strong claims about rational expectations or efficient markets from Scott Sumner. And perhaps the plain English meaning of those words would seem to require that prices and wages be perfectly flexible. However, it is equally obvious that Sumner does not believe that wages are perfectly flexible. Sumner's use of those terms would imply that there is no contradiction in claiming that "markets" rationally and efficiently take into account that wages are in fact sticky.

On the other hand, I am a Market Monetarist and I am not at all comfortable with any strong statements about the efficiency of markets or rational expectations. From my "Virginia School" perspective, the relevant question is what institutions, including what monetary regime, is the least bad approach for generating good results from markets that are inefficient from the standard of perfection and expectations that may be well short of "rational" by some objective standard.

In my view, the proper goal of a monetary regime is to provide a stable macroeconomic environment for microeconomic coordination. This is in the context of constant change--creative destruction. In my view, slow, steady growth in spending on output is the best (least bad) approach. It isn't perfect. But a gold or silver standard, a fixed quantity or growth path of some measure of the quantity of money, or a stable price level or inflation rate are all worse.

Sunday, April 21, 2013

Shawn Ritenour provides a critique of Market Monetarism on Mises.org. He charges:

Market monetarist theory and policy is unsatisfactory primarily because Market monetarists use a faulty theoretical framework in analyzing economic activity, they misunderstand how expectations enter into economic decision making, and they do not recognize the actual consequences of the monetary policy necessary to stabilize NGDP expectations.

Is there any truth to these claims? What about our "faulty theoretical framework?" He writes:

Most relevant and troublesome for evaluating NGDP targeting is that there is no such thing as aggregate demand that equates with aggregate supply at a single price level.

In fact, the social economy is made up of a vast network of distinct markets that are integrated into a complex division of labor through the inter-temporal production structure and the use of a general medium of exchange. Productive activity, therefore, is the result of a vast number of decentralized decisions made by a multitude of different entrepreneurs at different places in the production structure.

Well, I certainly have no particular dispute with his broad description of the market economy. I would add a bit more emphasis on creative destruction--innovation by entrepreneurs introducing new goods and services and new methods of producing existing goods and services.

So far, there is only one major difference. In my view, there is something in a market economy that is usefully framed as "aggregate demand." And further, it can equal "aggregate supply" at a single "price level." However, this framing of aggregate demand and supply is fully consistent with an understanding that a market order is a vast network of distinct markets. (I might add, interrelated markets.)

He goes on to discuss capital:

Capital is not a blob of homogenous schmoo (Foss and Klein 2012, pp. 105-30), so investment is not a homogenous ‘I’ (Garrison 2001).

I certainly don't think of capital as "homogenous schmoo," and would even grant that investment is not a homogenous "I." Of course, the nominal volume of spending on newly produced capital goods is an actual flow of money expenditure. It is a sum of the amount spent on a variety of different things.

But then, literally identical drill press machines can be used for a variety of purposes--continuing to produce some variety of automobile that no one is going to want or else producing washing machines in an insufficient quantity to meet an unanticipated demand.

That doesn't make the role of the price of drill press machines in coordinating their supply and demand irrelevant. Still, even if the price of drill press machines does coordinate the supply and demand for drill press machines, there is no guarantee that people will want to purchase all of the cars that some of the drill press machines were used to produce. For example, some other entrepreneur may have innovated and introduced a new type of car that people like better.

Similarly, the heterogeneous nature of capital goods doesn't mean that interest rates cannot coordinate saving and investment. However, even if saving and investment are coordinated, there is no guarantee that the particular capital goods being produced will help produce the products that people are most willing to buy. Because of creative destruction, it is likely that there will nearly always be "malinvestment." Capital goods will be produced that in retrospect should not have been produced. Instead, the resources would have been better used to produce something else.

Ritenour then states:

It is possible for people to decrease their demand for consumer and producer goods if they increase their demand to hold money. This would only lead to wastefully idle resources, however, if prices for these resources remained above market-clearing levels. This will not persist, of course, if prices are allowed to adjust (Hutt 1979, pp. 138-39).

Exactly, the first portion is exactly what aggregate demand is about. It refers to a situation where the quantity of money or the demand to hold money shifts resulting in either a surplus of money or a shortage of money.

A surplus of money is matched by a shortage of goods and services, and that is what it means for aggregate demand to exceed aggregate supply. A shortage of money is matched by a surplus of goods and services, and that it what it means for aggregate demand to be less than aggregate supply. And finally, if the quantity of money is equal to the demand to hold money, there is no shortage or surplus of output. Aggregate demand is equal to aggregate supply.

How does this relate to a "single" price level? If the prices of both final goods and resources adjust, then the real quantity of money will adjust to match the demand, closing off any surplus or shortage of money. The primary problem with Hutt's account is the assumption that the problem is necessarily the price of the resource in surplus and that it is the fault of obstinate labor unions preventing the adjustment.

While unions certainly could cause problems, if output prices fail to fall in the face of an excess demand for money, no amount of wage cutting will help reduce unemployment. The problem isn't with the relative price of some resource, the real wage in this instance, but rather with the price level and the real quantity of money. Further, there have been many historical instances where unions are unimportant, weak, or even nonexistent, and reductions in spending on output have resulted in extensive reductions in both output and employment.

Market Monetarists (and nearly all mainstream economists these days,) recognize that decreases in prices and wages increase real money balances and expand aggregate demand and that this can bring the real volume of sales into balance with the productive capacity of the economy.

Something like this is behind what is called the "natural rate hypothesis." In the long run, aggregate supply is vertical at the level of output that depends on the ability and willingness to produce goods and services. Aggregate demand solely influences the price level, including the prices of productive resources like labor.

Market Monetarists insist that expanding the nominal quantity of money is a much better way to raise the real quantity of money and bring it into balance with the real demand to hold money, simultaneously raising nominal and real aggregate demand so that it matches potential output.

By the way, Market Monetarists, like just about everyone else, recognizes that while an excess demand (shortage) of money is matched by an excess supply (surplus) of output, that output is heterogeneous. Each and every type of output has its own supply and demand, and the difference between each supply and demand, evaluated at the current market price, must be summed to find the net excess demand or supply of output.

If aggregate demand equals potential output, then the sum of the excess demands for all types of output is zero. This implies that there can very well be surpluses of some goods or services, but that these surpluses are matched by shortages of other types of goods and services.

In other words, it is almost exactly like what a naive interpretation of Say's Law claims must be true at all times. Supposedly, supply creates its own demand, and so while there may be a surplus, or glut, of some goods, this is because resources have been used to produce the wrong goods or services. The markets for the goods that were not produced because of the misallocation of resources are in shortage.

That prices fall in markets with surpluses and rise in markets with shortages is exactly how market signals are created to shift resources to produce the most highly valued goods. In my view, in a world of creative destruction, this is happening all the time. The market order is a system of constant mutual adjustment to constant change.

Ritenour continues:

Instead of allowing markets to clear via price adjustments according to subjective preferences, market monetarists advocate that monetary authorities bring about market stability by increasing the money supply. Such inflation, however, will not necessarily equilibrate the specific demand for and supply of money on the part of the individuals who are experiencing the excess demand. If prices and wages are that sticky, there will need to be a significantly large increase in NGDP to maintain equilibrium.

Actually, Market Monetarists favor having monetary authorities adjust the quantity of money either up or down to keep it equal to the demand to hold money. I find it odd that so many Austrians have this blind spot. It is always a critique of "inflation" (an increase in the quantity of money,) rather than considering the opposite situation where a reduction in money demand leads to a surplus of money, a shortage of output, and so a higher price level to reduce the real quantity of money and lower real aggregate demand to match potential output. Market Monetarists favor a reduction in the quantity of money in this situation.

The notion that an expansion in the quantity of money cannot accommodate an added demand to hold money because it fails to reach the specific individuals who want to hold more money is absurd. It ignores the fundamental proposition of monetary theory.

The individuals who want to hold more money actually do obtain it by spending less out of their current incomes or selling some asset they own. Of course, those from whom they would have purchased the goods or those to whom they sold the assets now have less money. As those people in turn restrict expenditures or sell assets, they rebuild their money holdings but the shortage shifts to still others.

The fundamental proposition of monetary theory is that the individual can adjust his or her actual money holdings to desired money holdings easily. It is rather that if the total quantity of money is fixed, then the market as a whole must adjust its desired money holdings to the existing quantity. For this adjustment to be consistent with economy-wide coordination, what must change is the price level, both of output and productive resources including labor.

If the quantity of money changes to match the increase in the demand to hold money, then those choosing to accumulate money holdings do so, but the effect is identical to what would have happened if they had chosen to purchase whatever is purchased with the newly- issued money. For example, if people choose to reduce expenditures out of current income and accumulate funds in their checking accounts, and banks create new money and make loans to various businesses, then the effect is the same as if those accumulating the money had instead made those loans directly to those businesses. Those accumulating money spend less on some goods, and the businesses spend more on other goods. There is no change in nominal GDP.

There is a reallocation of resources. But there would have been a reallocation of resources anyway. What an adjustment in the quantity of money allows is for this reallocation to occur without everyone in the market having to adjust their money prices (including wages) to increase the real quantity of money to match the demand. With an increase in the nominal quantity of money, those who need to expand production get a signal of increased nominal and real demand. Those who need to contract get a signal of reduced nominal and real demand.

This is as opposed to everyone getting a signal of reduced nominal demand, which is nearly always taken as a signal of reduced real demand and so creates the mistaken response of all firms cutting production. Only when the resulting surpluses of resources result in lower resource prices is the reality that all nominal opportunity costs have fallen (and real opportunity costs are the same) signalled to firms, so that they can expand both production and employment. The reallocation occurs anyway, with the signal to shift the allocation of resources arriving as some firms see falling costs turn their losses into profits sooner than others.

Anyway, since Market Monetarists favor a target growth path for NGDP, the notion that "there will need to be a significantly large increase in NGDP to maintain equilibrium," is beside the point. All that Market Monetarists propose is that increases in the demand for money be accommodated by increases in the nominal quantity of money so that they require no change in NGDP. We are not proposing to raise NGDP so that...I don't know what. No one ever adjusts their expenditure because they are short on money? I am not sure that would be possible.

As is so common, there is an implicit assumption that Market Monetarists are proposing to target real GDP or unemployment. Or perhaps more realistically, old arguments against targeting real GDP or unemployment are being trotted out where they don't apply. Market Monetarists are not proposing to increase nominal GDP whatever amount is necessary to close the output gap (raise real output to potential output) or lower the unemployment rate to the natural unemployment rate.

Retinour makes the following claim:

Additionally, decreases in demand are always experienced in particular markets. When there is either a decrease in demand or a decrease in supply in the face of elastic demand, total expenditures will drop. Note however, that spending is the effect of the changes in the preferences of buyers and sellers, not the cause of the decrease in demand or supply. Salerno (2006) shows how this applies to the broad social economy. Market-clearing prices (and quantities) are determined on every market by the interaction of individuals’ value scales on which goods are valued in relation to one another and to money. It is only after market equilibrium prices and quantities and, therefore, the value of money, have already been determined that “spending”occurs.

I am not sure how much of this is all due to Salerno or even if Ritenour correctly expresses Salerno's views. (I haven't read Salerno 2006.) But the way Ritenour describes it, Salerno is promoting an absurdly Walrasian account of the economy. First the equilibrium prices are determined, then everyone makes exchanges. I take a more "market process" view of the market economic order.

On the other hand, I don't think people choose to spend a certain amount of money on some particular good independent of the price and quantity combination it represents. From a micro perspective, the focus on spending comes from the budget constraint, keeping in mind that choosing to accumulate more money is a use of money income as well.

In later posts I will comment on Ritenour's criticisms of the Market Monetarist view of expectations and the actual consequences of changes in the money supply necessary to keep NGDP growing at a slow steady rate.

Saturday, April 20, 2013

Scott Sumner is the leading advocate of index futures targeting. I favor a very similar proposal, index futures convertibility. Both are really sets of proposals, and over time, there has been substantial convergence.

I have used the term "index futures convertibility" to refer to Sumner's proposals. To some degree, it is a matter of framing rather than substantive difference. My interest in this approach developed from something Leland Yeager mentioned in correspondence. We were discussing issues with "indirect convertibility." (Update: Kevin Dowd has made key contributions to the literature on futures targeting and I believe that his thinking on the matter developed in a way very similar to mine--modifications of indirect convertibility.)

Consider a gold standard. Paper money is redeemable with gold. Gold can be deposited in exchange for paper money. Add a central bank and a slightly different framing, and the central bank is obligated to buy and sell gold at a fixed price.

Of course, it is possible to make money out of gold--full bodied gold coins. It is possible that gold can be exchanged by weight. With a well-developed gold standard, some interbank settlements can be made with gold bars. And, of course, there is a long history of encouraging central (or commercial) banks to hold ample gold reserves. On the other hand, it is possible that no one would be interested in using gold coins and there are alternatives to settling payments by transferring gold bars.

Further, only minimal gold reserves are necessary for a gold standard. The obligation of a central bank to buy and sell gold at a fixed price requires it to adjust the quantity of money, most probably by open market operations with government bonds or other securities, so that the equilibrium price level results in a relative price of gold that clears the gold market. If an excess demand for gold develops at the official price, then the central bank must "tighten" monetary policy. If an excess supply of gold develops at the official price, the central bank must "loosen" monetary policy.

Why require the central bank to actually buy and sell gold? It is a simple rule that constrains the central bank to make the needed changes in monetary policy to keep the price of gold at its "official" level. The macroeconomic consequence of the regime is that the equilibrium price level depends on the relative price of gold, which in turn depends on the supply and demand for gold. Shifts in that equilibrium price level will be associated with shifts in spending on output, but in the long run, nominal GDP will equal potential output times the equilibrium price level.

Now, consider a multiple standard. In place of gold, paper money is redeemable with a bundle of commodities. It could be a fixed amount of gold plus a fixed amount of silver plus a fixed amount of copper plus a fixed amount of steel plus a fixed amount of aluminum. A more inclusive bundle is possible as well. A bushel of wheat plus a bushel of corn, plus a bushel of rice could be added.

With a multiple standard, commodity coins are either highly impractical or literally impossible. Settlement of payments with bundles of commodities is difficult and costly. Similarly, holding reserves made up of all of the various items in the bundle would be costly for central (or private) banks.

Some advocates of a multiple standard see holding large commodity reserves as a virtue. However, consider the opposite extreme where reserves are minimal to nonexistent. The central bank would be compelled to adjust monetary policy, presumably by buying or selling government bonds or other securities, such that the sum of the market prices of the items in the bundle totals to the "official" price. If the net supply and demand conditions for the various items results in upward pressure on the price of the bundle, the central bank must tighten monetary policy. If instead there is downward pressure on the total of the prices of the bundle items, then the central bank must loosen monetary policy.

What is the point of requiring the central bank to buy and sell the bundles? It is a simple rule that compels the central bank to adjust its monetary policy so that the total price of the bundle remains fixed at the "official" price. The macroeconomics of the regime would be that the price level would depend on the relative price of the bundle. If relative prices of the items in the bundle are subject to independent variation, the more inclusive the bundle, the more stable the relative price of the bundle. Of course, as the bundle approaches the makeup of output, then the price level becomes closer to depending on the price of the bundle relative to itself, which is fixed by definition.

How is it possible to overcome the cost of storing these commodities? Extending the items included in the bundle is desirable, but there is a trade off with cost of storage. Further, a substantial portion of output is made up of goods and services that cannot be stored at all. How can they be included?

Indirect convertibility requires that the issuer of money, such as a central bank, buy and sell some "redemption medium" that has a current market value equal to the sum of the market prices of the items in the bundle of goods that serves as medium of account. I tend to favor some kind of security, such as T-bills, but it is possible to explain the system using gold as a redemption medium.

Using gold as redemption medium, the central bank would buy and sell gold that has a market value equal to the sum of the actual market prices of the items making up the bundle of goods and services that defines the dollar. As before, what the central bank would actually do is use open market operations in government bonds or other securities to tighten monetary policy when the total price of the items in the bundle would otherwise tend to rise above its official price and loosen monetary policy when the total price of the items in the bundle would otherwise tend to fall below its official price.

Why require indirect convertibility? It is a simple (well, maybe not so simple) rule that compels the central bank to make the appropriate changes in monetary policy. Indirect convertibility is a substitute for direct convertibility.

How does indirect convertibility impose this constraint? If the total of the market prices of the items in the bundle should actually deviate from target, the central bank would be obligated to buy or sell the redemption medium, here gold, at a price different from the market price. Those trading with the central bank would make profit and the central bank would suffer financial losses. Because there would be transactions costs for those redeeming and selling or buying and depositing gold, this creates a range for variation in the total price of the bundle. To avoid ruinous financial losses, the central bank would be compelled to adjust monetary policy to keep the total price of the bundle within the range determined by transactions costs.

Indirect convertibility does not involve fixing the price of the redemption medium, gold in this example. The price of gold is free to adjust according to supply and demand conditions in the gold market. If the price of the bundle is on target, the central bank is obligated to buy and sell gold at the current market price, which is the same price that everyone receives on the market. There is no particular reason to for anyone to trade gold with the central bank. There would be nothing socially desirable about people buying or selling gold at the central bank.

Even if the price of the bundle deviates from target, the market price of gold isn't fixed. The market price of gold can vary with the supply and demand for gold, though the central bank is providing arbitrage profits to those who trade gold with the central bank.

The market forces created by indirect convertibility are very powerful in terms of keeping the price of the bundle within a narrow range. However, shifts in the relative supply and demand conditions of the bundle, particularly a narrow bundle, would require very sharp shifts in monetary policy that would result in perhaps very damaging shifts in nominal expenditure on output and on the broader price level. These would be similar to supply shocks.

Unfortunately, expanding the bundle creates measurement problems. The analysis above assumes continuous measurement. If the total price of the bundle is measured only periodically, requiring the central bank to make redemptions based upon the last measurement until the subsequent measurement could be extremely disruptive. This is especially true with monthly (or quarterly) measurements, but weekly or even daily measurements would hardly help.

Yeager suggested that perhaps the answer is to redeem now with some of the redemption medium, and then use the subsequent measurement of the price of the bundle to determine the additional amount of the redemption medium that must be provided to complete the transaction. I took this idea and developed it such that the central banks (or private banks, really) buy and sell the redemption media at its current market price and then after the subsequent measurement of the actual market prices of the bundel items, the amount transacted would be adjusted according to any deviation of the total market price of the bundle from the target price.

The "adjustment" is equivalent to a futures contract. If the total of the prices of items in the bundle is divided by the target price for the bundle, the result is an index number. The goal is for the central bank to adjust monetary policy to keep the price index at 100. Indirect convertibility using the subsequent measurement of the price index involves the central bank buying and selling the redemption medium at its market price along with a futures contract on the price index. If the price index is above target, the central bank must pay those who purchased the redemption medium and a the futures contract. If the price index is below target, the central bank must pay those who sold the redemption medium and a futures contract.

If those buying and selling the futures match, the central bank buys and sells equal amounts of the redemption medium and is hedged on the future contract. If the price index comes in above or below target, the central bank subsequently transfers funds between those who bought redemption medium and those who sold it.

If, on the other hand, there is an expectation that the price index will be above 100, then there is an incentive to redeem money for gold (buy gold) in order to obtain a futures contract from the central bank. If the price index does come in above target, the central bank would owe money to all of those who redeemed money. The central bank would be given a financial incentive to avoid that consequence by tightening monetary policy before the price level rose, keeping it on target at 100.

If there is an expectation that the price index will be below 100, then there is an incentive to sell gold to the central bank in order to sell the futures contract. If the price index does come in below 100, then the central bank would owe money to all of those from whom it purchased the gold. To avoid those losses, the central bank would need to implement an expansionary monetary policy.

The central bank would have a financial incentive to always adjust monetary policy to keep the price index on target. If the change in the price index was a bolt from the blue, and no one expected it, then there would be no incentive to buy or sell gold and buy or sell a futures contract on the index. There would be no financial consequences for the central bank.

If the deviation of the price index from 100 is so small that the payments are too small to cover transactions costs, then there is no incentive to trade the futures contract. The incentives only come into play with significant and expected shifts in the price index. The central bank is compelled by the threat of financial losses to tighten or loosen monetary policy to avoid any significant expected deviation of the price index from target.

Sumner pointed out that very next measurement of the price index would be inappropriate. That is because the redemptions would be occurring after some the prices used to calculate the index have already been measured. This argument suggests that purchases and sales of the redemption medium in April should be adjusted according to any deviation of the price index from 100 in May. This would be reported in early June.

Since the actual point of the regime is to impose financial losses on the central bank for significant anticipated deviations of the price index from target, there is no reason to actually require that some redemption medium be purchased or sold. The financial losses are solely from the futures contracts and it is to avoid those losses that the central bank uses ordinary open market operations to keep the expected value of the price index on target. Trading gold or some other redemption medium is just an unnecessary third wheel.

Exactly which future measure of the price index should be used is not obvious. Why not have the central bank buy and sell futures this month on the price index two or three months in the future rather than one month?

And finally, the futures contracts don't have to be on a price index. It is possible to use some other nominal macroeconomic magnitude--for example, an index calculated by deviations of nominal GDP from a target growth path.

The rationale for the system is to impose a financial penalty on a central bank that fails to adjust its monetary policy enough to avoid a significant expected deviation of the value of some policy goal from target. Those of us who believe that a nominal GDP level target is the best (or least bad) target, would propose that the penalty be for failing to adjust monetary policy to avoid a significant expected deviation of nominal GDP from its target growth path.

In my view, that is the purpose of index futures convertibility. It is a substitute for direct convertibility of money with a single easily storable commodity like gold or silver. Its benefit is that it constrains the central bank (or a private banking system if that can be managed) to stabilize expected spending on output rather than the price of gold. It is better to stabilize the growth path of spending on output rather than some measure of the price level. And it is better to stabilize the growth path of spending on output rather than have it fluctuate with the supply and demand conditions for gold.

Index futures convertibility necessarily has little connection with existing futures contracts which involve a changing price of the futures contract to reflect expectations of a changing price of the underlying commodity at the settlement date. Further, it has little connection to the typical futures contract which involves a storable commodity (or financial asset) and so allows hedging. The logic where futures prices drive spot prices by hedging and storage just does not apply.

The notion that there will be a futures contract on some macroeconomic statistic that the central bank is trying to stabilize, and the central bank will watch the price of that futures contract and vary its policy instrument settings to stabilize it, and particularly according to some mechanical rule, is fraught with difficulties. But I have never conceived of index futures convertibility as being anything like that.

Thursday, April 18, 2013

Noah Smith discussed the "circularity problem" with using market expectations of inflation to control monetary policy and Scott Sumner replied. There has been some discussion of index futures targeting on the Money Illusion, Sumner's blog.

The circularity problem is related to Goodhart's law. If the Federal Reserve were to begin targeting an index futures contract on nominal GDP, then those trading the futures contract would buy or sell depending on what they expect the Federal Reserve to do. The price of the index futures contract would stay at the Fed's target.

This becomes a problem if the proposed system is a mechanical rule tying open market operations or some other instrument of monetary policy to deviations of the price of the index future from target. The problem is that it may be necessary for the growth rate of base money (or the level of short term interest rates, if you prefer that framing) to change in order for nominal GDP to remain on target. But the "rule" is supposed to be that these instruments can only be changed if first the price of the index futures contract actually deviates from the target. But those actually trading the futures contract will know that the instruments of monetary policy will change until any deviation is reversed. Those who paid more than the target price for the contract will lose when the price falls again. Those selling the contracts for less than the target price will lose when the price rises again. They won't do that, and so if anyone bothers to trade these contracts at all, which is unlikely, the price remains on target always. But if the price remains on target always, then the instrument of monetary policy, whether base money or a policy interest rate, never changes. But that means that nominal GDP will likely deviate from the target.

Sumner's version of index futures targeting and index futures convertibility are a bit different, but can be subject to similar difficulties. The key difference is that the central bank doesn't watch a market price of a nominal GDP futures contract and then change its policy instrument according to changes in the price of the future, it rather buys and sells the future itself at the target price. That means there is no change in the market price of the future at all during the period it is being targeted. And so, there is never a change in the price of the future to communicate what the market thinks nominal GDP will actually be. The market signal that is generated is the central bank's own position on the contract, which only provides information about whether speculators on net believe that nominal GDP will be above or below target.

If there is a mechanical rule that requires that some instrument of monetary policy remain unchanged until speculators actually buy or sell the contract, then the problem of circularity still develops but it is slightly different and weaker. For the instruments of monetary policy to change as needed, speculators must trade the future. Their incentive to trade the future is the expectation that nominal GDP will deviate from target. But when they trade the future, the central bank adjusts base money or its policy interest rate in a way that keeps nominal GDP on target. The speculators would expect no profit after all. But knowing that, the speculators would never trade the index futures contract, and so the instrument of monetary policy would never change. If base money (or short term interest rates) never change, then nominal GDP will deviate from target.

However, it is pretty clear that the actual result would be that if the current setting of the policy instrument (say the growth rate of base money,) is expected to leave nominal GDP on target, then no one will trade the future. Only if the current setting is so far off that the expected deviation is large enough to cover the transactions costs and risk of taking a position on the contract would it be traded. The trades would then lead to changes in the setting of monetary policy so to reduce the expected deviation and the expected profit. However, an expected deviation would remain that compensates those trading the future for transactions costs and risk. The market (and presumably the central bank,) would all know that the policy instruments are being set at a level that will keep nominal GDP away from target.

Due to this logic, Sumner began long ago to speak of subsidies for the market. For example, the central bank should not try to charge trading fees to cover its costs of operating the system. The central bank should not insist that speculators keep funds in margin accounts that only pay low (or no) interest. Sumner has instead proposed that the Fed should pay extra high interest on the accounts!

Interestingly, this entire analysis assumes homogeneous expectations by the market. It is as if "the market" is treated as if it is a single individual. And it is certainly possible that everyone would know and agree that nominal GDP will either be above or below the target. However, it is possible that there would be disagreement. Certainly, this reflects the real world where we have some economists who predict massive inflation and others who insist that recession and disinflation will persist. While it remains true that those who expect nominal GDP to come in very close to target would not trade, the setting of the actual policy instrument would result in a balance between those speculators who believe it will come in sufficiently far above target to provide them with a profit and those speculators who believe it will come in sufficiently below target to provide them with a profit. While the expectations of those who believe that nominal GDP will be close to target aren't counted, because they don't bother to trade, the balancing of those with more divergent expectations does imply that the "market" made up of the actual traders would expect nominal GDP to remain close to target.

Sumner's earlier versions of the proposal were much like this, but some years ago he instead proposed a modified system where the central bank can adjust base money as it sees fit, even without there being any trades of the contract. The central bank creates a tentative target for base money, and then adjusts that tentative target according to the trades of the speculators. This means there is never a problem about the instruments of monetary policy remaining fixed until there are trades of the contract. There is never any situation where everyone, including the central bank, knows that nominal GDP will deviate from target in some particular direction, but no one has an incentive to close the gap. Quite the contrary, if everyone, which would include the central bank, knows what must be done to adjust expected nominal GDP to target, then the central bank will do it. All that would be left is trades by speculators with divergent expectations.

If the central bank always adjusts its policy instrument so that it is hedged, then the reason to take a position on the contract is because of an expectation that some other speculator will disagree and be willing to take the opposing position. I lean towards a similar approach where the central bank is free to adjust its instruments of monetary policy as it sees fit subject to the constraint that it buy and sell the futures contract at the target price. This also avoids the "problem" of the instruments of monetary policy remaining stuck until there are trades of the contract. If no one trades the contract, then the central bank adjusts monetary policy as it sees fit. It is like the contracts don't exist. However, it is likely that those with highly divergent expectations would trade the contract.

While Sumner tends to favor some mechanical rule to require adjustments in some policy instrument when the future is traded, I am skeptical. Instead, I contrast a "conservative" central bank policy of seeking to hedge versus an "activist" policy of taking a position on the contract. The central bank's position on the contract would show its confidence in its own internal forecast relative to that of the market. Again, it is likely that there will nearly always be trades in both directions by people with highly divergent expectations. If market sentiment begins to move in one direction or another, the central bank will find itself with a large and growing position on the contract. Presumably it will also be aware of whatever it is that is moving the market and also take action to offset it . A conservative central bank would take action sufficient to hedge its position--so that those who think it did too much are exactly balanced by those who think it did too little. But keep in mind, that those who think it did almost the right thing, and only slightly too much or too little, wouldn't bother to trade. A more activist central bank would have more confidence that it did the right thing and that "the market" is wrong. It would hold a position on the contract, betting against "the market."

Is there still a "circularity" hiding in here? Yes, there is. Any trade of the future must take into account the possibility that the central bank will adjust its instruments of monetary policy to offset the trade. The reason to trade is an expectation that even after the adjustment by the central bank, nominal GDP will remain significantly away from target. The reason to trade is that the speculator believes that either the central bank or some other speculator will hold the opposite position.

Now, if we assume that the central bank will always fully hedge and that there is only one speculator, then what that means is that the central bank will adjust its instruments of monetary policy so that the single speculator reverses his position on the contract. If that is true, then there is no selfish motivation for the speculator to ever trade the future. If there were only one speculator, then no trades would ever occur. But, of course, since the central bank is free to adjust the instruments of monetary policy, the requirement that it trade the index futures contract would impose no constraint on the central bank. But that isn't the situation in the real world.

Finally, if the central bank were to decide that it "wants" to let nominal GDP deviate from target, and "the market" got wind of this desire, then it would suffer heavy financial losses. And that, of course, is really the point of the proposed reform. It will focus the central bank on the policy target and allow no "tradeoffs" with other things that central bankers may value. Or rather, there will be a large financial bill for any effort to satisfy their personal preferences.

Sunday, April 14, 2013

JP Koning has an interesting post where he argues that the Bitcoin approach of a distributed payments network is superior to a centralized network like Fedwire. His emphasis is on the possibility of the physical destruction of the Fed's central node (and its two backups.) I would be interested in resiliancy regarding unraveling of trades.

Koning explains that the Bitcoin "mining" involves supporting and verifying the network. (It isn't just make work.) While I will grant that this is valuable work, I don't favor a monetary base that only increases or whose increase is limited in this way. Koning didn't comment on that aspect of Bitcoins.

Wednesday, April 10, 2013

Saving is saving; it is defined in all the textbooks as the funds that go into investment.

I found this incredible. "All" the textbooks define saving as the funds that go into investment?

I was quite sure that the textbooks that I have used recently define saving as income less consumption.

I have never once seen a textbook that has in bold face:

saving - funds that go into investment.

But to refresh my memory, I checked out the appropriate part of my current text. I am currently using Gwartney, Stroup, Sobel, and MacPherson. On page 533, they write:

Saving is income not spent on current consumption. Investment and saving are closely linked. Saving refers to the nonconsumption of income, while investment refers to the use of unconsumed income to produce a capital resource.

Sobel just happened to pop into my office while I was looking it up. He didn't think that saving was defined as funds going into investment. Still, the text is a group effort, and he focuses more on micro--he's a public choice economist. "Investment refers to the use of unconsumed income to produce a capital resource." Income used for production. Not the way I would frame it.

I checked the text that I was using before. Cowen and Tabarrok write on page 484:

Saving is income that is not spent on consumption goods. Investment is the purchase of new capital, things like tools, machinery and factories….. (they go on to explain that investment is not buying stocks and then finish up with)… Okay, let’s see how savings are mobilized and transformed into investments.

I could expand on their brief introductions, but I think the focus was on how saving is necessary to free up resources to produce capital goods, and capital goods allow for an increase in future output. That makes great sense to me, but of course I would appreciate the approach of micro-oriented free market economists.

So, I decided to check a few other texts from my shelf. Mankiw has a definition in the margin on page 267:

private saving – the income that households have left after paying for taxes and consumption.

But the section immediately before is called “Some Important Identities,” where he uses algebra to find that S = I.

I then checked out Krugman and Wells. On page 258, they have a section on the Saving-Investment Spending Identity. Like Mankiw, they use algebra to show that S=I. Only after that, on page 259, do they define private saving. It isn’t in bold or anything. They write,

“National saving is equal to the sum of private saving and the budget balance, where private saving is disposable income (income after taxes) minus consumption.” (I added the bold.)

So, the high Keynesians, from both the Republican and Democrat branches, do put the "identity" of saving and investment front and center, and only as an afterthought, do they bother to define saving as that part of income not spent on consumer goods.

It is interesting that the definition of investment as purchases of capital goods is treated as primary. Why isn't investment defined to be that part of income not consumed?

I certainly don't deny that national income accounting implies that aggregate expenditure generates an equal aggregate income. And that if aggregate saving is defined as aggregate income minus aggregate consumption, then it must equal aggregate investment, assuming it is the only sort of aggregate expenditure that is not aggregate consumption.

However, I would not start from expenditure equals income. Rather I would start with an individual choosing to either spend income on consumer goods and services now or else save by adding to net worth. Of course, that addition to net worth allows for an increase in consumption in the future.

Aggregate saving would not be found by taking aggregate income and subtracting off aggregate consumption. It would be found by summing up the individual amounts saved.

Similarly, I would not find aggregate invesetment by taking aggregate expenditure and subtracting off aggregate consumption. Instead, I would sum up the amounts that individual firms choose to invest. Of course, the purchase of new capital goods exands the capital resources they will have available for future production.

No way is saving, either individual or aggregate, the same thing as investment, either individual or in aggregate. They may be necessarily equal, but any kind of focus on individual choice screams they are different sorts of things.

In my view, the interest rate is the price that coordinates saving and investment. Why would there be any need for a price to coordinate two things that are necessarily equal? Of course, it is desired saving and desired investment that need to be coordinated.

Is that really so unusual? Consider apples. The supply of apples is the amount of apples that firms are able and willing to sell at various prices. The demand for apples is the amount of apples that households are able and willing to buy at various prices. The market supplies and demands are built up from the supplies of individual firms and the demands by individual households. The price of apples coordinates the quantity supplied and demanded.

Of course, the actual amount of apples purchased is always exactly equal to the actual amount of apples sold. If the demand for apples was identified with the number of apples purchased and the supply of apples was identified with the number of apples sold, then they would always be equal, by definition. This would be exactly the same thing as the claim that saving is always equal to investment by definition. But that wouldn't mean that the price of apples has no role in coordinating the desired purchases of apples with the desired sales. And, of course, quantity supplied and demanded are actually defined in terms of desired amounts.

Consider the labor market. The demand for labor is the amount of labor firms choose to utilize at different real wages. The supply of labor is the amount of labor households choose to provide at different real wages. The real wage coordinates quantity supplied and demanded.

But suppose the demand for labor was defined to be the amount of labor firms were actually utilizing and the supply of labor was defined as the amount of labor actually being provided by households. Those two amounts would be equal by definition. What possible role would the real wage have in coordinating those "demands" and "supplies" of labor? Of course, it would still be possible for the real wage to coordinate the desired "demand" for labor and the "desired" supply of labor. And that is exactly how the supply and demand for labor are defined--in terms of the desired amounts.

The apples that are being supplied and the apples that are being demanded are the same thing. It is the supplying of them that is not the same as the demanding of them. Only by focusing on actual transactions does an empty tautology of apple purchases equaling apple sales cause confusion.

The labor being supplied and the labor being demanded are the same thing. It is the supplying of the labor that is not the same thing as the demanding of it. Again, only by focusing on actual transactions does an empty tautology of labor utilized and labor done cause confusion.

But saving and investment are different things. And the supplying of saving and the demanding of investment are also different. But somehow, a focus on the identity of the total amount of expenditure on goods and services and the total amount earned from selling goods and services, when combined by a subtraction of consumption, results in confusion.

Somehow the equality of actual saving and investment is considered more important than the defined equality between the actual amount of apples sold and the actual amount of apples purchased. It is considered more important that the equality between labor utilized and labor done. But it is not.

It is certainly possible (and I think likely) that a decrease in income can lead to a reduction in desired saving. If desired saving was greater than desired investment, and desired investment was somehow maintained, then a contraction in income could lead to desired saving falling enough to become equal to desired investment. This would be the paradox of thrift in terms of quantity of saving supplied and quantity of investment demanded. That is, in terms of desired saving and desired investment.

However, the interesting and important condition is the coordination of saving and investment when aggregate income equals the productive capacity of the economy. That is, the allocation of resources between production of consumer goods and services and capital goods constrained by the scarcity of currently existing resources.

A better way to use the algebra, or really the arithmetic, of consumption, saving, income and investment is to see that the interest rate that keeps the quantity of saving supplied equal to the quantity of investment demanded is also the interest rate that keeps the sum of the quantity of consumption demanded and the quantity of investment demanded equal to potential output--the productive capacity of the economy.

That realized saving is equal to realized investment because realized expenditures equals realized income adds nothing but confusion. I suppose that is another reason to avoid the textbooks written by high Keynesians.

The conventional wisdom is that Keynes confused identities with equilibrium conditions. I am sure that Mankiw and Krugman keep them straight, but their approach to introducing saving and investment doesn't help.

As for Sumner, the answer is that no, not all of the textbooks define saving as the funds going into investment.

Sunday, April 7, 2013

In my view, an important cause of the Great Recession is the practice of the Fed and other cdentral banks of targeting consumer price inflation.

The rapid economic development in China and India in recent years has resulted an increase in the relative price of oil. The growing Chinese and Indian middle classes are buying and driving cars and so buying and using gasoline.

Developed oil importing countries, especially Japan and Europe, but also the U.S., face increasing oil prices. This results in higher gasoline prices, which raises the consumer price level.

While inflation-targeting central banks often look at measures of "core inflation," they do so because of the large volatility in energy and food prices. The prospective development of the Chinese and Indian economies are not matters of volatility, but rather a long term trend of rising relative energy prices.

To keep consumer inflation on target, other prices must rise more slowly to offset the rising relative price of energy. Perhaps most importantly, money wages must grow more slowly as well. This is essential to maintain full employment while slowing the rise in the prices of domestically produced consumer goods and services. It reflects the slower growth in real incomes in developed countries implied by the increasing relative price of imported oil.

Further, if employer compensation plans create a large element of inertia in the growth path of wages, then the level of wages can rise substantially above the long term growth path. This can be corrected by an immediate drop in wages. If the actual impact of high unemployment is just a gradual slowing of wage rate growth, shifting wages to a lower growth path will require wages growing even more slowly than the long run trend (already slower) for a substantial period of time.

Of course, if the increase in the relative price of oil is large enough, then the equilibrium growth rate for real wages in developed countries could be negative for a substantial period of time. (Once India and China have completed their "catch-up" growth phase, and have incomes similar to those in the developed world, then this process will be complete.)

However, because oil can be stored, and more importantly, left in the ground in anticipate of price increases, the price of oil does not smoothly adjust with growing demand in China and India. The expected growth in energy demand results in a large immediate changes in the current price oil.

This suggests that even if the trend equilibrium growth rate in real and nominal wages in developed countries would remain positive, the actual adjustment process would be a large sudden drop in real wages and then a return to growing wages at something close to the previous trend. With consumer price inflation targeting, this would require a rapid large decrease in money wages. Again, if money wages actually have inertia on the current growth path, and only adjust by a slower growth rate, then the need to adjust to a much lower growth path for real wages would suggest a much longer period of high unemployment as the below long term trend growth rate in money wages very gradually allows equilibrium wages, growing along the lower growth path, to catch up.

To the degree that China and India depend on exports to developed countries for their growth, then the recession in developed countries caused by inflation targeting would slow economic growth and so the growth of energy demand. This will tend to lower energy prices in the world, and so dampen and even partially reverse the decrease in the equilibrium growth path of wages. This should dampen the recession in the developed world.

With nominal GDP level targeting, the process is much different. Wage rates in developed countries, especially Japan and Europe, can remain on an unchanged growth path. The price of imported oil increases, and so do consumer energy prices. The CPI and other measures of consumer prices rise more rapidly. Real wages in developed countries, along with other real incomes, grow more slowly or even fall.

However, lower real incomes in developed countries is going to adversely impact imports from countries like China and India. This would dampen the growth in China and India and so the prospective demand for energy there. However, the result would be a dampening of the CPI inflation in developed countries rather than reducing the depth of recession.

With inflation targeting, a sudden, unexpected increase in the inflation rate, and so the price level, is ignored. To some degree, the fact that current oil prices involve a forecast of future demand allows some of the impact on measures of consumer price inflation to be ignored. Unfortunately, to the degree that this process can be predicted, a central bank that is targeting expected future inflation should force the economy into a recession so that the growth path of equilibrium money wages will be forced down with real wages.

Would central bankers describe this process as worrying about inflation expectations becoming unanchored? Is it any accident that it was just that concern by central bankers in 2008 occurred right before a modest recession turned into a disaster?

Saturday, April 6, 2013

The Bank of Japan promised to undertake substantial quantitative easing recently and long term interest rates fell at first and then rose back. Scott Sumner has become embroiled in a debate as to whether these changes in long term interest rates are consistent with Market Monetarism.

In my view, Market Monetarists insist that it is possible that an expansion in the quantity of money can increase all interest rates. This is one reason why Market Monetarists have been very critical of Bernanke's rationale for quantitative easing--that its purpose is to lower long term interest rates. More fundamentally, it is a reason why Market Monetarists are skeptical of interest rate targeting. Having a central bank manipulate the quantity of money (or its own yield,) so that short and safe interest rates are pegged at some periodically changed level has some disadvantages. (Unfortunately, there is no perfect alternative. All alternatives have disadvantages and advantages.)

With a simple monetary thought experiment, where there is a permanent increase in the growth rate of the quantity of money, the long run impact on long run nominal interest rates is positive--roughly proportional to the increase in the growth rate of the money supply. If there were an an equilibrium with a 2 percent growth rate of the money supply and a 5% long term nominal interest rate, then raising that growth rate of the money supply to 3%, will roughly result in a 6% long term nominal interest rate.

What about short term interest rates? Eventually, they will rise by 1% as well. However, during the adjustment process, they might fall at first and then only later rise. Any such short term perverse change in short term nominal (and real) interest rates should be slightly reflected in long interest rates as well.

If instead of a permanent increase in the growth rate of the money supply, the thought experiment is a permanent increase in a target for the inflation rate, then the long run equilibrium result is the same. Interestingly, if the shift is well known and credible, the temporary distortion of interest rates -- lower short term interest rates in the short run, should be lessened. In the limit, all nominal interest rates increase with the increase in the inflation target with no change in real interest rates.

But suppose there is a credible unchanged inflation target, and an increase in the quantity of money. If "the" market believes that inflation will always remain on target, then nothing of the thought experiment of a permanent increase in the growth rate of the money supply would apply. There is no proportional increase in nominal interest rates due to the Fisher effect because there is no increase in the inflation rate.

If "the" market believes that this increase in the quantity of money is inconsistent with the inflation target, then "it" will expect this increase in the quantity of money to be reversed in the future. The immediate impact of the increase in money growth could still be a liquidity effect on short term nominal and real interest rates. And further, that effect would be slightly reflected in both real and nominal long term interest rates. If the reverse of this excessive money growth simply returns short term interest rates to where they would have been anyway, then long term bonds have slightly lower real and nominal yields due to the excessive money growth. On the other hand, if reversing the excess growth in the money supply required higher interest rates than would otherwise be necessary, then this would partially or perhaps fully offset the tendency of the liquidity effect to lower nominal and real long term interest rates.

Where does this leave us with Japan? If the proposal to increase the inflation target was fully credible, then that should have been sufficient to raise long term nominal interest rates. If "the market" expected firms to immediately begin raising prices at the new rate, then it would have the same effect on short term rates as well. The later announcement of large amounts of quantitative easing would have no impact on expected inflation and so no "Fisher effect" raising long term interest rates.

Only if the announcement of the new inflation rate was not credible because "the" market believed that the central bank would not increase the quantity of money enough to reach the new inflation target, would the added information that the Bank of Japan would make these purchases have a positive effect on expected inflation (moving it towards the target) and so a positive "Fisher effect" on long term interest rates.

Suppose the Fed answered Market Monetarist prayers and announced a target 5% growth path for nominal GDP, commencing in a year at a level about 10% higher than its current value. Many Market Monetarists have argued that if the Fed's actions are credible, then the demand for base money would fall. Further, "Wicksellian" natural interest rates would rise at all maturities. In our view, the Fed should reduce the quantity of base money and allow market interest rates to rise with growing demands (and reduced supplies) of credit. This effects should happen with the announcement of the new policy.

But suppose that after a month or two the Fed announces that it remains recommitted to keep interest rates at zero for an extended period of time and further, commits to some large increase in the quantity of base money, specifying that it will purchase long term government bonds. With the policy of nominal GDP level targeting being fully credible (by assumption,) these increases in the quantity of base money would be expected to be temporary. The demand for base money has fallen. But the effect of the large temporary increase in base money (expanded from an already greatly excessive level) should be short run liquidity effects that depress short term interest rates. And lower short term interest rates for a time should slightly lower long term interest rates.

The announcement of the nominal GDP level target regime could cause increases in long term nominal and real interest rates--if it was credible. But if that is true, a subsequent announcement of quantitative easing would lower nominal and real interest rates again, at least partially reversing the initial increases. As for exchange rates and stock prices, the lower real interest rates would tend to lower the exchange rate and raise stock prices.

Of course, if the Fed announced the new target, and it was not credible because "the" market doesn't believe that the Fed will increase base money enough when necessary or allow interest rates to fall low enough, then the Fed's announcement of the large increases in base money or its commitment to keep interest rates very low could raise long term nominal interest rates. In other words, as Sumner explained, "it's complicated."

Thursday, April 4, 2013

Scott Sumner has been giving a series of lessons on basic monetary theory. He discusses a commodity standard and then a fiat currency. In my view, there are two framings of a fiat currency. Both have elements of truth and provide some insight. I see Sumner as constantly leaning too far in the direction of what I call the paper gold framing. The alternative framing is the credit money framing.

With a gold standard, gold is mined from the ground, and the mining industry spends the new money it creates. A competitive mining industry would have little direct concern with the impact of its mining on the relative price of gold. As long as its purchasing power is high enough to make mining the gold profitable, then it will be mined and spent.

Gold has a variety of uses, both monetary and nonmonetary. If one is doing monetary analysis, it is convenient to ignore the nonmonetary uses. The quantity of money, determined by the profit seeking efforts of the mining industry, and the demand to hold gold, determines the relative price of gold, and so the price level in terms of gold.

The paper gold framing treats paper money issued by the government like it is gold. The government's money printing operation replaces the gold miners. The government prints money into existence and spends it. This ties directly to government finance. It could reduce ordinary taxes, fund extra government programs, or pay down government debt, understood as interest bearing government bonds.

The paper gold framing naturally leads to worries that the government will print money and spend it with no more concern for its purchasing power than does the gold mining industry. Since the cost of printing currency is very low, it would be profitable to print currency until its purchasing power is very low.

The paper currency has approximately zero use for anything other than money. The quantity of paper money created by the government and the demand to hold it determine its purchasing power and the price level in terms of paper money.

The paper gold framing is especially useful to understand an irresponsible government that simply prints money as needed to finance its expenditures. It also fits quite well in a scenario where this source of government funds is limited by quantity. The government is permitted to print money and spend it, but it can print only a limited amount of currency per year. A fixed percent increase provides a "ceteris paribus" constant inflation result.

Of course, if the demand to hold money is subject to large fluctuations, then rule fixing the growth rate of currency printed by government will result in fluctuations in spending on output, short run fluctuations in production and employment, and long run fluctuations in the price level. This suggests that limiting government money creation by a quantitative rule is undesirable.

Suppose that the rule instead mandates that the quantity of money be adjusted to keep the price level or nominal GDP constant or growing at a stable rate. Now, rather than money simply being printed and spent by the government at either an uncontrolled and unconstrained rate or a limited, more responsible rate, the quantity of money must sometimes decrease.

Gold miners don't collect gold and destroy it for any reason, much less in order to make sure that its relative price doesn't fall. If paper money is somehow controlled to stabilize something other than its own quantity, then it is no longer like paper gold.

The credit money framing instead treats paper money as a debt instrument. Initially, it was a promise to pay commodity money on demand. This promise was made by private banks, often under conditions of imperfect competition. Usually banks offered deposit accounts and allowed payments "on the books," well before banknotes were discovered. Rarely, and almost entirely due to government requirements, did banks operate on a 100% reserve basis. The money issued by banks was a promise to pay, not a claim to commodity money being stored.

With the credit money framing, tangible hand-to-hand currency is fundamentally identical to money in deposit accounts. What years ago were entries on the books of banks are now entries in their computers. A bank deposit denominated as one dollar has a value of one dollar for the same reason that the paper money issued by a bank would have a value of a dollar. The issuing bank must stand ready to pay them off on demand. And, of course, both are used to make payments.

There is, of course, a difference between banknotes and deposits. It is technically easier to pay interest on deposits than on banknotes. Historically, banks did not pay interest on most banknotes, which made them a source of profit to the individual bank. A competitive system of traditional banks, offering banknotes and interest bearing deposits, while making specialized bank loans, will compete away these profits. In effect, this would make the profits from issuing bank notes essential to compensate for what would otherwise be "excessively" high interest on deposits, "excessively" low interest on loans, or perhaps excessive operating costs--"excessive" numbers of bank tellers.

A monopoly issuer of banknotes can capture these profits. Long ago, governments granted that monopoly privilege to a single bank. And that is the actual reason for the existence of central banks. They can profit from borrowing at a zero nominal interest rate by issuing banknotes. With a monopoly on this business, they face no direct competition.

Why did the government's provide this benefit to a particular bank? In exchange for being able to obtain loans at a low interest rate. When the national debt was high, particularly when it was growing due to war-time deficits, the central bank would do its patriotic duty and lend to the government at below market interest rates.

In the modern era, central banks have been nationalized. The Federal Reserve, for example, receives market interest rates on the government debt it holds, covers its operating costs, pays a modest fixed dividend to the member banks that nominally own it, and then give the remainder back to the Treasury. The Treasury claims the residual profit that is generated by the ability of the Federal Reserve to borrow at a zero nominal interest rate.

Competitive note-issuing banks were able to largely out compete coin-issuing government mints and they were also able to operate with very slim commodity money reserves. To keep commodity money in circulation, governments prohibited the issue of small banknotes. To encourage banks to hold commodity money reserves, governments banned the option clause. And most obviously, governments mandated minimum reserve requirements.

With a central bank monopolizing note issue, the remaining deposit banks replace commodity money coins with banknotes issued by the central bank as vault cash and find it convenient to keep some reserves on deposit with the central bank. The deposit banking system has no need for more than minimal commodity money reserves.

Oddly enough, it is possible for a central bank to also operate with minimal gold reserves. Even if households and firms use commodity money coins, then central bank can provide them to commercial banks as they need them, with the central bank purchasing them from the mint. The central bank can pay the mint by crediting its deposit account and the mint can pay for bullion by writing a check against the central bank.

The primary constraint on a developed central bank or competitive banking system imposed by a commodity standard is that the market price of bullion cannot rise so high that it becomes profitable to do round trip arbitrage. For example, to redeem money for gold and sell it, and then redeem the money received for more gold.

For both a central bank in a gold standard world, or any individual competing bank, the "solution" to excess demand for gold bullion is to sell short term securities. The key effect of "open market sales" is to contract the quantity of money and raise short term interest rates. This tends to reduce the demands for all goods and services, including gold bullion. And so, the credit money issued by central bank and the banking system that is denominated in terms of some commodity-defined unit of account roughly purchases the amount of the commodity that defines the unit of account.

In such a monetary order, the unit of account, such as the dollar, is defined in terms of some commodity, such as gold. The media of exchange, including paper money, are denominated in terms of the unit of account. The banking system, including the central bank, keeps the market price of the commodity equal to the defined price by some system of redeemability, though often indirect. For example, a dollar-denominated deposit at a commercial bank is redeemable for paper currency issued by the central bank which is redeemable in foreign exchange. By open market operations or manipulating its discount rate, the central bank makes sure that the market price of gold remains pegged at its defined price.

Given such a system, it becomes untenable to treat the nonmonetary uses of the commodity as just a slight distraction. The media of exchange are made up of a variety of debt instruments. The medium of account, such of gold, has a supply depending on the mining industry and a demand that in the limit would be solely for "industrial" purposes, such as jewelry.

With a credit money system, it is possible to change the medium of account without changing the unit of account. For example, it would be possible to switch from gold to silver or silver to gold. All that would change is that rather than adjusting the quantity of money to keep the market price of gold at the defined price, the banking system would begin adjusting the quantity of money to keep the market price of silver at its defined price.

More interesting would be more complicated standards. For example, a symmetalic standard combines two metals, like both silver and gold. Coins could be minted out of electrum, the alloy of silver and gold, but there is no need for commodity money coins. Central bank or private bank deposits could be redeemed with a fixed amount of gold bullion along with a fixed amount of silver bullion.

Now, if the banking system, with or without a central bank, is obligated to redeem banknotes and deposits with both a fixed amount of gold and a fixed amount of silver, these monetary instruments remain debt instruments. Further, there is no need for direct redeemability. For example, suppose that central bank redeems its money with both a fixed amount of foreign exchange drawn on a country on the gold standard and a fixed amount of foreign exchange drawn on a country on the silver standard.

Rather than worry too much about symmetalism, consider a true multiple standard, with the unit of account defined as fixed amount of pig iron plus a fixed amount of wheat plus a fixed amount of aluminum, and so on. Suppose a central bank promises redeemability not in the actual commodities, but in foreign exchange sufficient to purchase all of those items. A paper dollar or dollar deposit is redeemable in the number of Euros sufficient to purchase a fixed amount of pig iron plus the amount of Euros necessary to purchase a fixed amount of wheat plus the amount needed to purchase a fixed amount of aluminum and so on.

Whether or not such a system would be better or worse than simple commodity standard, it is clear that the paper money and deposits remain debt instruments. The actual operation of such a system would require monetary system, either competing banks or a central bank, to use ordinary open market operations to adjust the quantity of money so that the sum of the market prices of the items in the bundle add up to the defined price of the bundle.

Finally, suppose that rather than using some system of direct or indirect redeemability to compel a central bank, to undertake the needed open market operations to keep the market price of the bundle at the defined price, some alternative motivational scheme is used. Further, rather than using open market operations to keep the market price of a bundle goods at the defined price, instead, a price index calculated using that same bundle of goods and open market operations are used to keep the price index at 100.

What is the best way to frame such a monetary order? In my view, paper money issued by a central bank committed to a stable price level is better framed as credit money. With a modern, nationalized central bank, the tangible paper currency is a type of government debt. It just pays zero nominal interest. It is nothing like paper gold.

Now, suppose that the rule is instead to to keep nominal GDP growing at a slow steady rate, so that the price level remains at 100 on average. Which is better? The paper gold framing or the credit money framing? If the demand for money of any sort, whether hand-to-hand currency monopolized by a central bank, or an interest bearing checkable deposit issued by a commercial bank, should decrease, the quantity of that particular type of money must be decreased. The issuer must pay back what has been borrowed.

In my view, it is best framed as credit money. Of course, if the central bank is obligated to buy and sell index futures contracts on nominal GDP, the monetary regime has something similar to redeemability. And, of course, if government-issued currency is replaced by private banknotes, then, the paper money is clearly debt instruments of some bank, and nothing like paper gold.

Tuesday, April 2, 2013

Congressman Kevin Brady, Republican from Texas, is calling for a Centennial Monetary Commission to review the performance of the Federal Reserve over the last Century. Steve Horwitz recently wrote an op-ed at U.S. News endorsing the idea.

I agree.

In my view, the Great Depression was strike one. The Great Inflation was strike two. The Great Recession was strike three.

I think it is time for fundamental change. I don't think the Federal Reserve has mostly done a good job. I have no interest in protecting the Fed.

On the other hand, I am not at all sympathetic to returning to the monetary regime (and banking system) the U.S. had developed circa 1913.

And there is little doubt that a Centennial Monetary Commission could make recommendations, that if acted upon, would result in a much worse system.

But the monetary regime in the U.S. is broken. I am willing to take some chances to see it fixed.